If Paul Krugman (and others) are right, classical monetary policy goes out the window in a world where nominal interest rates are zero bound. All the usual monetary tools at the disposal of central bankers just don’t work.
In which case, central bank tactics arguably have a right to get more spicy. Fed mandates might even justifiably be extended to new more exotic markets too.
Looking at Ben Bernanke’s own thoughts from 2003 with regards to the situation in Japan (H/T Pragmatic Capitalism) it’s clear the Fed Chairman has always felt there’s room to get experimental.
Among his yet to be trialed ideas, for example, is price-level targeting instead of pure inflation targeting. The idea is that once deflation starts to grip, there’s not much point in a central bank trying to achieve say a 2 per cent inflation target. For one thing, the policy worries believers in the quantity theory of money, since the chances of overshooting the inflation target arguably become greater because more power has to be deployed so as to achieve an increasingly far-off target.
Secondly, an increasingly unobtainable inflation target only compromises the credibility of the central bank. A jump from deflation to disinflation, for example goes un-rewarded… despite being a relatively big achievement.
Which leads nicely to Bernanke’s second point. By the time you’re in a protracted deflationary period, it’s clear that central bank policy should be more about expectation management than anything else.
As he noted in his speech, the reason a price-level target might work is because it might restore inflation expectations, in the way an explicit inflation target usually does:
By clarifying the objectives of the central bank, an explicit inflation target can help to focus and anchor inflation expectations, reduce uncertainty in financial markets, and add structure to the policy framework.
It’s what you might call Jedi Economics. If you believe in the inflation force, the force will be with you.
So the question is, are Jedi economics — a.k.a. central bank mindtricks — actively being deployed already?
We’d argue there’s definitely some anecdotal evidence they are.
Of course, to really appreciate the scale of the ruse, and just how widespread it may be, let’s consider the following — also from Bernanke’s speech:
Eggertsson and Woodford (2003) have advanced a second argument for a price-level target for Japan in an important recent paper on monetary policy at the zero bound. These authors point out (as have many others) that, when nominal interest rates are at or near zero, the central bank can lower the real rate of interest only by creating expectations of inflation on the part of the public. Eggertsson and Woodford argue that a publicly announced price-level target of the type just described is more conducive to raising near-term inflation expectations than is an inflation target.
One way to understand their argument is to imagine that the public expects the leaders of the central bank to take more aggressive actions, the further they are from their announced objective. Now suppose that, in an economy experiencing a stable deflation, the central bank leadership announces a fixed inflation target but then makes no progress toward that target during a given period. Then in the next period, the central bank is in the same position as previously, in terms of its distance from its objective; hence, by hypothesis, the central bank has no incentive to increase its effort to meet the announced target, and the public has no reason to expect it to do so. In this respect the inflation target is too “forgiving” an objective; failure is not penalized, nor is greater effort demanded. In contrast, under a price-level-targeting scheme, continuing deflation combined with an upward-sloping path for the price-level target causes the size of the price-level gap to increase over time.
Eggertsson and Woodford show, the expectation that an increasing price level gap will give rise to intensified effort by the central bank should lead the public to believe that ultimately inflation will replace deflation, a belief that supports the central bank’s own objectives by lowering the current real rate of interest.
So the theory is that to get an economy out of a zero-bound liquidity trap — in which most investors only feel comfortable sitting in the very best quality securities, such as government debt, even if it’s at the expense of capital destruction — the only possible way to snap them out of the collective trance, is via the creation of inflation expectations.
In this way, QE2 “money printing” was arguably one of the biggest Jedi mindtricks ever. A ruse to induce inflation expectations within the shadow banking community. Arguably it even worked (for a while). Look to what degree Bill Gross became an inflationista during the period. (Or was he in on the mindtrick?)
Unfortunately the ruse failed because it pushed inflationary forces into emerging markets and commodities rather than back into the domestic economy itself. Importing inflation, after all, doesn’t quite have the same positive effect as home-grown inflation (look at Britain).
Of course, now that investors have suddenly and very sharply snapped out of the QE2 inflation trance — as we can tell from the fall in breakeven rates on US Treasuries — we’re arguably back where we started. What’s more, QE is unlikely to be a viable bluff again.
An important lesson from Jackson Hole 2010 – FT Alphaville
Introducing the 2011 deposit crisis – FT Alphaville
Shadow banking – from Giffen goods to Triffin troubles – FT Alphaville
Struggling back to neutral, (monetary) policy edition– FT Alphaville